If you’re a fan of the financial aid and student loan industry, you’ve seen recent turmoil around how federal student loans are distributed and increased downward pressure on interest rates. Additionally, a planned interest rate reduction for federally subsidized Stafford loans will take effect in July 2010, from 5.6% to 4.5%. In July 2011, there will be another rate cut expected to 3.4%.

Thanks to the Student Aid and Fiscal Responsibility Act (SAFRA) passed in March, private banks will no longer be able to originate federal student loans for students attending schools affiliated with the Federal Family Education Loan Program (FFEL). The effect of this new bill is that starting in July, banks participating in FFEL will lose a substantial source of income and will start looking elsewhere to recover lost income. Due in part to these changes, banks are lowering their interest rates and fees to attract borrowers who are not normally as interested in applying for a credit-based loan. You may be wondering, “What does that mean to me?” Two main things:

  1. Lower interest rates = less money paid over the life of the loan
  2. Historically low index rate = potential to pay more over the life of the loan

Sounds counterintuitive, right? Let’s analyze the terms and discover the hidden meanings.

Interest rate: the percentage of a sum of money charged for its use; this number is generally derived from a variable index rate plus a “margin.”

For example, if you slow me down $ 100 for a year at 5% interest, when I pay you back … the total will be $ 105. That $ 5 is what you charge me for borrowing the money.

Index: A statistical indicator that measures changes in the economy in general or in particular areas. For student loans, the Fed Funds Rate and the London Interbank Offer Rate (LIBOR *) are typically the most widely used ratios (The Free Online Financial Dictionary).

* For more information on LIBOR and the federal funds rate, they are published daily in the Wall Street Journal and available online at a wide variety of financial websites.

These indices change over time based on the performance of the economy. If the economy is good, they tend to be higher; if it is doing it wrong, or in our case, rebounding from a severe global recession, they tend to be lower. All of these changes are methods of financial control to help expand or slow down the economy. If you are inexperienced in economics, the important thing to remember is that the Fed does not want our economy to grow or contract too quickly; Stable and gradual growth is always preferred to rapid growth because it is less financial risk and easier to forecast. Now that you know what these terms mean, I invite you to think about how a historically low index rate could affect your student loan. To gain a firm understanding, there are a few key points to keep in mind:

  1. All private student loans have variable interest rates (which means they change); rates are generally readjusted every 3-6 months
  2. Low index rates = economy in recession or an economy that is poised for high growth
  3. Interest rates are based, at least partially, on indexed rates.

When you connect the dots, you see that there is a clear possibility that as the economy improves, so will the indices. The result? You variable the interest rate will increase along with the index and cost more money in the long run. Sounds negative, right? Not necessarily. Because of these historically low index rates, you can actually get a private student loan (assuming you have a good or excellent credit score, or a solvent co-debtor) at lower interest rates than a federal PLUS parent loan. The game here is really finding a loan that has the best of all worlds. In this case, you want to find one that has a low “margin” number. Do you know when you see a loan offer and it says something like LIBOR + 3% or Prime + 2.5%? That “+ X%” is a margin.

So your goal, fearless loan finder, is to find a private loan that has a low margin and a low to medium index rate. The more stable the index, the more stable your interest rate will be. Note that you are not required to accept the first loan offer you receive and that you have a 30-day window to apply for loans without applying a credit penalty. As a responsible borrower, you are encouraged to shop around for loans and find a product that meets both your needs and your financial ability.

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